Elric Lloyd-Langton 2nd September 2009
Market Maker Tactics
If there is one particular part of markets functions I think investors should learn more about, it would be how Market Makers work, their tactic and functions. Yes, we can get hung up on global and local markets, of course. However, there is surprisingly little known about this area as a topic, yet it’s importance is often misunderstood and ignored in equal measure. With the help of a little inside knowledge from and ex MM friend of mine; lets see if we can help explain their role a little.
Are they out to get you? Erh, not really, but they don’t care about you or the company either. They look after themselves and their broker clients. Like investors and traders, they can be caught on the wrong side of a market. However, unlike you and I, the MM can employ a number of tactics to get them out of a tight spot. Some perfectly legal, some morally questionable to the damn right illegal.
Orderly Market? It is the MM roll to know what is being discussed and what it news worthy related to the stocks they keep a book on, so it should be no surprise to learn they follow BB’s and press, etc. After all, knowing where the weak holders are, is meat and drink to the MM. Part of the roll is identifying the BBM or as I like to call them, lemming investors, sometimes referred as dumb money, a phrase coined stateside.
MM’s trading BBM stocks it is very easy for them to get trapped into being short in dealing in a fast moving market and or illiquid market because most MM's in this stock are what are called “wholesalers” this means they don't have retail brokers “working” the stocks. So they have to rely on what's known as the “call” from larger retail houses. If a “Big” retail firm like IG or E-trade calls to purchase say 10,000 shares of a stock, they expect to get an “execution” from that market maker. If he turns them down, or only gives a partial fill then the “Big” firm will go to another MM. If this second MM “fills the order” then that “Big” firm has a moral obligation (Yes, moral obligation….I know!) to continue to give future “business” in that stock to that MM whom did the business for them. This will go on until he “fails” to perform and so on. So the last thing a MM needs is to get a bad rep from a big boy in the city.
Popular Myth Contrary to popular opinion the “Big” firms Do NOT necessarily go to the “Low Offer” to fill a buy order (Or high bid for a sell). They “Go” to who they think will perform to fill the order and expect that MM to “match” the “low offer” in the case of a buy. Even though this MM might in fact be the “high bid” and not really want to sell any more. As a wholesaler he must perform or he will get a reputation as a “non-performer” with the “Big” houses and will cease getting “calls” which means he will soon go out of business. I mentioned above that this activity is very significant to BB stocks. I say this because most of the trades in these BB stocks are “unsolicited” and are done through discount houses.
With the above groundwork laid, let me try to explain how market makers get short even if they like the Company; Let’s say that a stock (A) has been lying quietly at 25p bid 50p offered. A limit order comes into one of the MM's to Buy at 50p for a 1000 shares. Prior to this trade that MM may be “flat” (neither long or short any shares). He fills the order and is now short 1,000 shares. He may raise his bid hoping to find a seller to “flatten” out his position. But before he realizes it a wave of buyers have come in and cleared out all the 50p offers. Now the stock is 50p bid 75p offered. Here comes that “Big” firm he just sold the 1,000 shares to at 50p with another bid for 1000 at 75p. He makes this print. Now he is short 2,000 at an average of .625. The market keeps moving and now its 75p bid 1.00 offered. Now he has to make a decision. Just like investors, MM Hate to take a loss. So 9 times out of 10 he will now sell 2000 at 1.00 making him short 4000 but with an average 81p. At this times he would love to see a seller at 75p so he can cover his short and make a few quid; but instead the market keeps moving up. Now it is 100p to 125p and here comes the buyer again at 125p. He doesn't want to lose the call so now he needs to sell 4,000 at 125p to keep his break-even point above the bid. Now he is short 8,000. Market moves up to 125p bid 15p0 offer here comes the buyer now he feels he must sell 8000 here because “stocks don't go up forever”. Now he is short 16,000. And so on and so on. If the stock keeps moving up, before he realizes it he could be short 50k or 100k shares (depending how big his bank is). Finally, the market closes for the day and on paper he may look all right in that his “break-even” price may be around the closing price. But now he has to figure out how to entice sellers so he can cover this short. It is important to note that if this happened to one MM it has probably happened to most all of them.
Some ways MM's entice sellers; Run the stock up with a “tight spread” in a fast market, then “open” up the spread to slow down the buying interest. After it has “cooled off” for a little while lower the offer below the last trade right after a small piece trades on the offer then tighten the spread so that the sellers feel they can take a “quick profit” by “hitting the bid” on the tight spread. Once the selling starts the MM's will walk it down quickly by only making small prints on the way down with the tight spread. Another way is by running the stock up in the morning, averaging up their short then use the above technique to walk it down in the afternoon. Hopefully after doing this for several days, it will demoralize the buyers. The volume will dry up and the sellers will materialize thinking that the game is over.
Contrary to popular opinion, MM usually Do Not Cover in Fast moving markets either Up or Down if they are short. They Short More. They usually try to cover after the frenzy is out of the market. There are many other techniques they use but the above are the most popular. This technique works about 9 times out of 10 particularly in a BB market. However, that is because 9 out of 10 BB stocks are BS. Remember what I said above. Most MM's don't have a clue as to the value of a Company until they get trapped. If the Company has solid fundamentals and a bright future. Then the stock will do very well. And the activity that caused the situation will prove to even help the future stock activity because it created an audience.”
Market Maker's Operating Procedure The savvy long-term investors never chase stocks up. For the most part that is momentum players and day traders where most of it or what follows is BBM money. If your desire is to make money and not become saddled with a BBM tag, you need to find a company that has been quietly getting on with its roll without making a song and dance with every ramptastic RNs. Typically, amped stocks will have several BB threads in their young life on AIM, for example. That is a red flag! Back on track…The savvy investors will once they have performed their due diligence, will accumulate and no amount of MM games will shake them. MM hate a stock that has a good core of long term investors not fearful of accumulating. Typically, a good solid company will have a spike, a retracement and a period of trading range. This is often a sign the MM is working a sell order into the market, yet there is a price pinch at which point the savvy long term holders continue to accumulate. The savvy investors are not interested in trading against the public mind or the BBM money. That's where the majority of the money can be made but even more can be made if the base of a stock is held extremely strong by investors.
Importance of Volume MMs follow a simple code of business when making a market in a stock. That is the level that stocks will seek that yields the most volume. Now this is very important because they make money on the volume buying at the bid and selling at the ask. In other words, by making the market they are buying low and selling high. Now smart money adheres to that rule, so do all the market makers. They could careless whether the stock is at 50p or 200p. All they care about is the action thus being able to sell stock at the offer (The high) and buy stock at the bid (The low). To increase their profitability, they make the spread as great as possible on as many shares as they can especially if the volume falls off.
When they have mostly all “buy” orders, that's not the price that's going to yield the most volume. They need both buy and sells to get the maximum action. Remember, MMs play the volume. If the volume decreases and there are mostly Buys that become a one-way volume, Buy volume. So what they do is let the stock run up to a price where it runs out of steam. They fill all the buy orders there that they can and then comes the pullback one way or another naturally or induced. Make no mistake, MMs know TA traders know where the resistance and support for a stock is and they WILL use this knowledge to relieve them of their stock if they need to cover a Buy side order. This will create the pull-back they can mop up the weak holders share and flip them to those averaging down or trying to catch the bounce. At some price, the stock will be relatively stable and yield the most volume.
Now that is the average price you will see The average price is the point where a stock seeks a level where MMs can profit on the most volume. So during the day that is the price that MMs and momentum/day traders want to see the stock at. Why? Because they know BBM money was chasing the price thing up. Most of the time, the MMs love a flurry of Market Orders which is a dead sign of an artificial run or momentum.
Tree Shake Shake the tree and watch the lemmings fall. This is a tactic often used to in an illiquid stock and low volume, which is often the case. If an MM has a buy order (outside normal market size) and no volume on the sell side, he will “shake the tree” to see if there are any weak holders about. This may be after a rally where buy pressure is still prevalent. MMs feel or rather know with some degree of certainty it is very likely BBM money will want to sell back those shares relatively quick on the slightest drop.
Now somewhat comfortable with this logic the MMs merely short sells into the buying and attempts to take the stock down in an effort to “shake out” the weak. Since it is tough to know for sure whether a move is the beginning of a trend, or a routine shake out, this type of deception works quite well for the MMs. What the long-termers do to a stock is surprise the MMs because instead of falling the shorting has no effect and the price goes up. Now that puts the MM at selling low through shorting and thus having to buy high in order to cover. And if it goes pear-shaped, the MM is caught short and the strength of the buy is overpowering the MM will want to cover his short position. So the MMs call up one of his friendly MMs and says some like “the weather is sure rough today.” The MM along with the other “friendly MM initiates a down tick about the same time. Now this can also be done with a certain amount of shares such as an infamous 100 shares flag. This down tick gives the illusion of weakness designed to hopefully begin the bear raid of selling. The fickle, fearful, day trader, momentum and short term begin to sell out allowing the MM to cover his short position at lower prices.
How to play their game, or NOT The most effective way to combat the MM manipulative game is to go long and become a long-term investor by slowly accumulating and holding thus drawing the MMs out of its defenses making them as naked as their short position. By managing your investment not overstretching your finances you do not become meat and drink for the MMs. No, use funds you can leave invested for the long haul, the battle, because ultimately, you are at war with the MMs and the BBM. Simply becoming a distressed seller make the life for the MMs much easier.